Question

Please describe the circumstances of the following case study and recommend a course of action. Explain your approach to the problem, perform relevant calculations and analysis, and formulate a recommendation. Ensure your work and recommendation are thoroughly supported. Case Study: A vacuum manufacturer has prepared the following cost data for manufacturing one of its engine components based on the annual production of 50,000 units. Description Cost per Month Direct Materials $75,000 Direct Labor $100,000 Total $175,000 In addition, variable factory overhead is applied at $7.50 per unit. Fixed factory overhead is applied at 150% of direct labor cost per unit. The vacuums sell for $150 each. A third party has offered to make the engines for $60 per unit. 75% of fixed factory overhead, which represents executive salaries, rent, depreciation, and taxes, continue regardless of the decision. Should the company make or buy the engines?

Answer 1

Answer:

In this case, an analyst is presented with recommending the best option between internal production and external acquisition of  goods (outsourcing) for resale.  Through relevant quantitative and qualitative analyses it will be decided whether the company should make or buy the engines or vacuums.  To make 50,000 units of the engines, production costs will be incurred as given in the question.

After considering the qualitative factors, including availability of production capacity, space, and labor, the next would be to undertake a  costs /benefits quantitative analysis of making the engines in-house versus buying from outside for resale.  The outcomes are then compared to understand their financial effects.  The option that makes better financial sense or that is more profitable should be chosen because the payoff outweighs the other and the company's assets and stockholders will be better off with the more profitable option, either in the direction of making more profits or reducing the cost profile.

In any make or buy decision situation, the costs that are relevant are the costs that change with the option.  Any costs that do not change with a chosen option is disregarded.  This include items like depreciation and other indirect fixed costs.

b) Computations:

1. To make:

Description                    Cost per Month

Direct Materials                    $75,000

Direct Labor                        $100,000

Variable factory overhead $375,000 ($7.50 x 50,000)

Total variable costs =        $550,000

Selling price =                 $7,500,000 ($150 x 50,000)

Contribution =                $6,950,000

Fixed factory overhead     $150,000 (150% of $100,000)

Net Income                    $6,800,000

2. To buy:

Cost of goods  - $3,000,000

Selling price       $7,500,000

Contribution      $4,500,000

Fixed costs            $112,500 (75% of $150,000)

Net Income       $4,387,500

c) The company should go ahead and produce the engines internally.  This is far more profitable, all quantitative factors considered.

Explanation:

In arriving at a decision in a make or buy decision situation, only relevant costs that change with the option should be analysed.  Fixed indirect costs and depreciation should not be considered.

From the above quantitative analyses, the company will make a contribution (profit) of $6.95 million instead of $4.5 million if it chooses to make the engines internally.

Even a review of the bottomline (after factoring in the fixed costs) shows that the company would make a net income of $6.8 million by producing the engines in-house.  The net income above the buy option is more than $2 million.